WASHINGTON - Worker productivity, the key factor in rising living standards, slowed sharply in the final three months of the year while wage pressures increased.

The Labor Department reported Wednesday that productivity, the amount of output per hour of work, increased at an annual rate of 1.8 percent in the October-December quarter, down from a 6 percent performance in the July-September period. The slowdown reflected the fact that overall economic activity weakened considerably in the final three months of last year.

Labor costs rose by 2.1 percent in the final three months of the year, after having fallen by 1.9 percent in the third quarter and 1.1 percent in the second quarter.

The increase in productivity in the fourth quarter was nearly double what economists had been expecting while the rise in labor costs was slightly lower than had been expected.

Ian Shepherdson, chief U.S. economist at at High Frequency Economics, said he looked for productivity to slow further in 2008, reflecting an extremely weak economy in the first half of the year.

For the year, productivity rose by 1.6 percent, a slight rebound from a 1 percent gain in 2006 but both years were well below the average annual increases of 3.2 percent turned in from 2000 through 2004.

Productivity determines whether living standards can rise because it allows businesses to pay their workers more because of their increased output without having to raise the cost of their products, which increases inflation.

The country went through a two-decade period of stagnant increases in productivity following the oil shocks of the early 1970s. However, starting in 1995, productivity began showing bigger improvements, reflecting all of the investments that had been made in computers and other efficiency-enhancing equipment.

Economists are currently debating whether that substantial gain in productivity is now waning or whether the slowdown is just a temporary reflection of the deterioration of the overall economy.

The Federal Reserve closely monitors changes in productivity and labor costs for clues on underlying inflation pressures.

Analysts do not believe the fourth-quarter slump in productivity and rise in labor costs will alarm Fed policymakers who are focused at the moment on fighting the sharp slowdown in overall economic activity rather than worrying about inflation.

The Fed cut a key interest rate by a half-point last week, a reduction which followed a rare three-quarter-point cut delivered following an emergency meeting eight days earlier. The two cuts represented the most aggressive easing on the part of the Fed in more than two decades.

The central bank hopes the rate cuts will bolster sagging consumer and business confidence and keep a prolonged housing downturn and severe credit squeeze from pushing the country into a recession.

Congress and President Bush are also working to keep the current six-year-old expansion from faltering. The president included in the $3.1 trillion budget he unveiled on Monday a $145 billion economic stimulus plan. The House has passed a version of the measure and it is currently being debated in the Senate.

The 1.6 percent rise in productivity for all of last year was a slight improvement from a 1 percent increase in 2006 but was still well below the gains of 4.1 percent in 2002 and 3.7 percent in 2003.

For all of 2007, labor costs rose by 3.1 percent, a slight increase from a 2.9 percent rise in 2006.

Source: Associated Press